Make a Bet on Calmer Post-Election Waters

by Tyler Craig | November 5, 2012 12:46 pm

Last Friday’s sharp rejection of Thursday’s mini-breakout illustrates the difficulty of divining short-term direction amid a market correction. During such volatile periods, multi-day swings often are displaced by choppy seesaw action that frustrates bulls and bears alike.

In such a climate, fortune favors the nimble, while misfortune hounds traders slow to reorient themselves to quick market turnarounds.

Click to Enlarge The rapid return of risk aversion is perhaps best illustrated by the action in the U.S. dollar on Friday. Since plumbing new yearly lows in September, the PowerShares DB US Dollar Index Bullish Fund (NYSE:UUP[1]) spent much of the past six weeks building a bottom, which now has been completed with a strong, high-volume breakout above both multi-month resistance as well as the 50-day moving average.

While a strong dollar generates a bit of a headwind for stocks[2], it really disrupts the bullish argument for commodities in general and precious metals in particular. Gold bugs were squashed Friday as the strengthening dollar exacerbated the slide in gold and silver. Provided the greenback continues to see capital inflows, it likely will be difficult for precious metals to stage a sustainable advance.

Of course, the main event this week will be the finale to the hotly contested presidential election. Rather than wagering on the endgame of the race and its implications on stock direction, though, how about betting on a variable that is arguably much easier to predict: volatility?

The general behavior of implied volatility heading into a market moving event like an employment report, fed announcement or election is as follows: In anticipation of the event, traders typically bid up option premiums as they jockey for position in preparation for what could be a large market move. While some participants snatch up put options for protective purposes, others buy upside calls in hopes of profiting from a rapid rise in price following the event. All told, this uptick in demand causes a lift in implied volatility.

Following the event — when an unknown becomes a known — option traders typically unload their positions, thereby driving down implied volatility.

Traders comfortable betting on this post-election volatility drop might consider selling options ahead of the event in some fashion. Those looking for a neutral play could sell an iron condor — which consists of simultaneously selling a bear call and a bull put spread in the same expiration month — on the S&P 500 via the SPDR S&P 500 ETF (NYSE:SPY[3]).

Click to Enlarge Traders could sell the November 133-138 put spread along with the November 145-150 call spread for a net credit of 94 cents. The max reward is limited to the initial 94 cents received at trade entry and will be captured provided the SPY remains between $138 and $145 by November expiration next Friday. The profit range is highlighted in the accompanying chart.

The maximum loss is capped at $4.06 and will be incurred if SPY rises above $150 or falls below $133. To reduce the risk, however, traders could close the position if SPY climbs above $146 or drops below $137.

As of this writing, Tyler Craig did not hold a position in any of the aforementioned securities.